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by L. Randall Wray

However, as Scott Fullwiler argued after a previous such attempt, whenever Krugman describes the “intermediation” process that banks supposedly engage in, it’s actually like a “flashing neon sign” saying “I don’t know what I’m talking about”.

A year ago, he tried to argue that he, not Minsky, truly understands banking. Banks cannot actually create deposits “out of thin air” because they need reserves for clearing. This time, he rediscovers James Tobin’s classic paper, “Commercial Banks as Creators of Money” (a paper known by everyone who works in the field, so it is hard to believe he forgot about it). In Krugman’s interpretation, this paper proves that you really don’t need to know anything about the mechanics of bank lending. While banks couldcreate deposits, since they won’t stay put on the creator’s balance sheet, in practice, “Banks are just another kind of financial intermediary, and the size of the banking sector — and hence the quantity of outside money — is determined by the same kinds of considerations that determine the size of, say, the mutual fund industry.”

Well, yes. And no.  But confused.

Last time, I argued that his earlier piece set economics back a century. . This time, I suppose you could say he’s brought us up to mainstream theory of 1982. There’s been a lot of water under the money theory bridge since then. And, in any case, Tobin was trying to correct the foibles of mainstream theory—there were plenty of nonorthodox economists who didn’t follow orthodoxy down the “exogenous” money path.

As I discussed in my 1990 book, Money and Credit in Capitalist Economies: the endogenous money approach, the 1980s debate over “exogenous” versus “endogenous” money was in a sense a reprise of the Banking School-Currency School controversy of the early 19th century. The Banking School took the endogenous money side, while the Currency School was a precursor to Milton Friedman’s Monetarist exogenous money. The earlier debate was settled when Britain tried to follow Currency School doctrine; the later debate was settled with the adoption of Monetarism in both the US and UK in the late 1970s. In both cases, exogenous money flopped. Endogenous money emerged victorious. As it turns out, the central bank cannot control the money supply. No central bank in a modern developed country even tries any more. Exogenous money is as dead as a doorknob.

The 19th century debate didn’t really have the notion of the deposit multiplier that after the 1920s slowly made its way into US textbooks. Unfortunately, those who haven’t been paying attention don’t recognize that the death of Monetarism was also the death of the deposit multiplier. Endogenous money not only means that the central bank cannot control the money supply but also that it cannot control reserves. It accommodates bank demand for reserves. Hence there is no “deposit multiplier” but rather a “divisor”—there is an ex post ratio of reserves to deposits but it is not constraining.

Now, are banks unique, or are they just intermediaries like money market mutual funds—that take in “deposits” and lend them out?

The answer to both is “NO”. Banks are not unique, and they are not intermediaries. Nor are money market mutual funds, if you get right down to it.

As Minsky always said, “anyone can create money”, but “the problem lies in getting it accepted”.  Both banks and mutual funds “create money” in the sense that they issue money-denominated liabilities. Both have to “get them accepted”. Banks are more special than others because government gives them special protection. When times are good, this might not matter much—the “money” created by other types of financial institutions are “just about as good as” the deposits created by banks. In bad times, that reverses and the liabilities created by shadow banks are about as desired as a fork in the eye. Paul McCulley put it this way:

Over the last three decades or so, the growth of “banking” outside formal, sovereign-regulated banking has exploded, and it was a great gig so long as the public bought the notion that such funding instruments were “just as good” as bank deposits. Keynes provides the essential – and existential – answer as to why the shadow banking system became so large, the unraveling of which lies at the root of the current global financial system crisis. It was a belief in a convention, undergirded by the length of time that belief held: shadow bank liabilities were viewed as “just as good” as conventional bank deposits not because they are, but because they had been. And the power of this conventional thinking was aided and abetted by both the sovereign and the sovereign-blessed rating agencies. Until, of course, convention was turned on its head, starting with a run on the ABCP (asset-backed commercial paper) market in August 2007, the near death of Bear Stearns in March 2008, the de facto nationalization of Fannie Mae and Freddie Mac in July 2008, and the actual death of Lehman Brothers in September 2008. Maybe, just maybe, there was and is something special about a real bank, as opposed to a shadow bank! And indeed that is unambiguously the case, as evidenced by the ongoing partial re-intermediation of the shadow banking system back into the sovereign-supported conventional banking system, as well as the mad scramble by remaining shadow banks to convert themselves into conventional banks, so as to eat at the same sovereign-subsidized capital and liquidity cafeteria as their former stodgy brethren.

But that does not make “shadow banks” or “commercial banks” mere intermediaries. Both “finance” positions in assets by issuing liabilities. Their liabilities are variously called deposits or “NOW” accounts or MMMF shares. Ultimately, however, only insured deposits are guaranteed to never “break the buck”. For that reason, banks are special. This has nothing to do with them being “money creators” versus “intermediaries”—it has to do with sovereign government backing.

And if a bank suffers a clearing drain, it goes to the Fed Funds market to borrow reserves, or to the Fed’s discount window. Often shadow banks have relations with commercial banks to provide clearing for them. A recent—somewhat shocking—discussion at the Fed indicates that the Board is thinking about letting a wide range of firms, including nonfinancials, hold reserve accounts. If that happens, even the shadow banks and the nonbanks might do their clearing directly at the Fed.

Heck, then I guess we could say “anyone can issue money and the Fed will make sure it is accepted”!

I hope Paul Krugman will move on to a 21st century understanding of banking. As I pointed out recently, even the credit raters at S&P have joined us in explicitly throwing out the deposit multiplier. It’s about time.

On another matter, MMT critics often argue that we oversimplify—or are just wrong—when we “consolidate” the central bank and treasury for the purpose of opening our discussion of spending with a sovereign currency. According to critics, the Fed and Treasury are independent and never shall the twain meet. The Fed might go vigilante on the Treasury, refusing to do its banking.


Here are two relevant quotes, one from the Fed and one from McCulley:

Fed: “You have to remember that we are a legal creature of Congress and that we only have a mandate to concern ourselves with the interest of the United States,” Dennis Lockhart, president of the Atlanta Fed, told Bloomberg Television’s Michael McKee. “Other countries simply have to take that as a reality and adjust to us if that’s something important for their economies.”

McCulley (in the paper cited above): “We pretend that the Fed’s balance sheet and Uncle Sam’s balance sheet are in entirely separate orbits because of the whole notion of the political independence of the central bank in making monetary policy. But when you think about it, not from the standpoint of making monetary policy but of providing balance sheet support to buffer a reverse Minsky journey, there’s no difference between Uncle Sam’s balance sheet and the Fed’s balance sheet. Economically speaking, they’re one and the same.”